derivatives

November 06, 2014

Products being developed for large, sophisticated players is usually a sign of a maturing market. And the Bitcoin market is no different.

Until recently, derivatives based on Bitcoin, such as those offered by ICBIT and BTC Oracle, were suited only for small, individual traders. But recent months have witnessed the development of two types of derivatives contracts that are suitable for institutional investors and large merchants.

Derivatives are contracts whose value changes based on the value of some underlying security, currency, commodity, or price index. Derivatives can be used to hedge risk, speculate, or take an investment position in the underlying asset or price index.

Derivatives come in a wide variety of forms, such as stock options and S&P futures. But the new institutional-grade Bitcoin derivatives take forms that are less common.

The first Bitcoin derivative for sophisticated parties to come to market was the TeraExchange (Tera) Bitcoin forward. The Tera contract works in the following way: First, on the initial trade date, the buyer and seller enter into a contract for a certain amount expressed in U.S. dollars. The minimum contract size is $1,000. Then, on the contract's settlement date, the buyer pays the seller in cash if the price of Bitcoin in U.S. dollars has increased since the trade date. The amount the buyer has to pay the seller is based on the size of the contract and how much the price of Bitcoin has appreciated since the trade date. On the other hand, if the value of Bitcoin decreases after the initial trade date, the seller makes the cash payment to the buyer.

The Tera Bitcoin forward is traded on a platform regulated by the Commodity Futures Trading Commission (CFTC) and known as a swap execution facility. The platform provides prices and matches up parties, but does not clear the trade or otherwise assume any risk related to the parties not paying each other. The Bitcoin swap is uncleared, meaning that the buyer and seller assume the risk that the trade will not properly settle. But as is typical with swap agreements, the Bitcoin forward requires collateral to be posted when the trade is entered, and for parties to make adjustments based on the market value of Bitcoin. Using collateral reduces counterparty risk.

The first Tera Bitcoin derivatives trade was executed on October 9, 2014, between digitalBTC and another party. digitalBTC is a publicly listed Australian a company that provides Bitcoin mining, trading, and liquidity-provision services. digitalBTC seems to have entered the forward to gain exposure to Bitcoin as opposed to hedging its Bitcoin price risk that arises from holding bitcoins due to its business activities.

A second type of Bitcoin derivative is under development by SolidX partners. According to its press release, the SolidX agreement will take the form of a total return swap, which is a relatively common type of derivative instrument that emerged in the late 1980s. A total return swap enables a buyer to get investment exposure to an underlying asset--including its gains and losses--without having to actually own the asset or necessarily even pay any money upfront.

A total return swap is structured the following way: the buyer pays the seller a set rate in exchange for receiving payments that reflect the gains, if any, from owning an underlying asset. If the underlying asset produces a gain from interest income or market appreciation, the total return swap buyer gets paid that amount. If the underlying asset suffers a loss, the the buyer must pay the swap seller the amount of the loss (in addition to the set rate).

The SolidX Bitcoin total return swap will give its buyer the same gains and losses it would have as if it purchased bitcoins outright (minus the fixed rate it pays to SolidX). Because bitcoins qualify as a type of "commodity" under the Commodity Exchange Act, the SolidX swap will be regulated by the CFTC.

The following diagram shows some basic structural differences between the Tera and the SolidX bitcoin swaps.

Both instruments permit parties to effectively invest in bitcoins without actually owning any. The benefit of doing so is that it allows merchants and financial institutions to gain exposure to Bitcoin without having to deal with anti-money laundering issues and other regulatory concerns that could arise from directly holding bitcoins.

There are some important differences between the Bitcoin forward and the swap, however. Only the Tera Bitcoin forward offers parties the ability to "short" the Bitcoin market and gain from a Bitcoin price decline. Merchants, investors, and others that hold bitcoins can benefit from Tera's forward giving them the ability to hedge their Bitcoin price exposure.

Another major difference is the source of counterparty risk. With a Tera Bitcoin forward, the other party to the trade will be the source of counterparty risk. With the SolidX Bitcoin swap, SolidX itself will be the source of the counterparty risk. The ability of SolidX to make good on its end of the bargain will depend on how well it translates Bitcoin price gains into an income stream for the buyer.

Gaining exposure to Bitoin may have different accounting and cash-management consequences with each instrument as well. The Tera Bitcoin forward only triggers the primary payment obligation on the settlement date. By contrast, the SolidX swap may require a more frequent exchange of cash flows. As a result, the SolidX product would have a more direct impact on earnings and liquidity. On the other hand, the buyer of the SolidX swap may not have to post collateral or any cash upfront, which may make the instrument more attractive than an equivalent Tera Bitcoin forward.

Ultimately, differences between the Tera Bitcoin forward and the SolidX Bitcoin swap will depend on the particularities of the terms of the trade and counterparties involved.

With the advent of these two products, and likely many more on the way, the Bitcoin economy will attract a wider range of commercial and financial market participants.

August 06, 2014

Bitcoin price volatility isn't what it used to be. Compared to its meteoric rise and fall in 2013, recent months' fluctuations around $600 seem tame.

But despite the fact that Bitcoin has become boring--at least for speculators--widespread adoption of the cryptocurrency will not happen unless merchants and others can shield themselves from its volatility.

And companies are stepping up to meet that need.

A recent entry is Coinapult’s Locks, a service that allows customers to lock in the price of their bitcoins to an existing currency like dollars or Euros, and even gold. The Bitcoin Mercantile Exchange is another relative newcomer, and reportedly went live last week (on July 28, 2014).

Companies hedging fluctuations in currency prices is nothing new, of course. Firms that operate internationally routinely use derivatives contracts to reduce risk. Coca-Cola, for example, uses forwards and options to hedge currency price risk from selling in Europe and Japan.

So as companies increasingly offer derivatives to hedge Bitcoin price risk, an open question is how Bitcoin derivatives will be regulated. It's an open question because the Commodity Futures Trading Commission (CFTC) has yet to take any public action regarding Bitcoin derivatives even though they fall directly under the CFTC's jurisdiction.

Nonetheless, the CFTC's existing regulatory framework is clear enough to make sense of how Bitcoin derivatives are likely to be regulated. In broad terms, CFTC regulation has three components most relevant to the Bitcoin economy: futures regulation, the distinction between futures and forwards, and swaps regulation.

Futures

Futures contracts, whereby one party agrees to deliver an underlying asset or its cash-equivalent at a later time at a pre-specified price, fall squarely within the CFTC's jurisdiction. They're standarized with respect to all terms except for price and are required by law to trade on regulated futures exchanges.

Virtually any type of economic good or measurable quantity--from crops to prices to the weather--can be the basis of a futures contract. This is due to the Commodity Exchange Act's extremely broad definition of "commodity." When it comes to Bitcoin, the only question right now is whether the CFTC will categorize bitcoins as "excluded commodities" like currencies or other financial interests, or as "exempt commodities" like gold and other precious metals.

Futures Versus Forwards

In contrast to futures are forward contracts. Forward contracts also lock in a price for an underlying commodity at the inception of the contract. But unlike futures, forwards are not standardized, do not trade on exchanges, and physically deliver the underlying commodity. In the words of the CFTC, the “primary purpose of a forward contract is to transfer ownership of the commodity and not to transfer solely its price risk” as is the case with futures.

Importantly, forward contracts are not regulated by the CFTC.

While it may be obvious whether a particular contract is a future or a forward, when the CFTC or courts distinguish between the two, the most important factor tends to be whether the contract was intended to physically deliver a commodity (and hence is a forward) or whether it was meant to enable parties to speculate on the price of the commodity (and hence is a future). A contract is also more likely to be considered a forward if it is not fungible and not traded on a venue that functions as an exchange (by, for example, taking on counterparty risk and enabling parties to enter into offsetting contracts).

Whether a contract is a regulated Bitcoin futures or an unregulated Bitcoin forward in principle should be no different that futures and forward in other types of commodities. If the agreement is highly standardized and traded without the intent or ability of the parties to physically deliver Bitcoins, it may be deemed a futures agreement. Contracts that contemplate physically delivering bitcoins or that are nonfungible are likely to be considered forward and fall outside of CFTC regulation.

Importantly, the fact that bitcoins are digital assets and cannot be "physically" delivered in the traditional sense does not matter: the CFTC recognizes that intangible assets (which may include bitcoins) may be the subject of a forward contract so long as "ownership of the commodity can be conveyed in some manner and the commodity can be consumed.” Bitcoin ownership can certainly be conveyed and, if bitcoins are deemed by the CFTC to be intangible, spending or trading them likely qualifies as being "consumed."

Swaps

Swap agreements are another common way for companies to hedge price risk. In a swap, two parties agree to exchange cash or other another commodity based on the price of an underlying asset or event. Ford Motor Credit, for example, uses cross-currency swaps to reduce its exposure to exchange rate changes arising from international debt financing.

Due to reforms ushered in by the Dodd-Frank Act, swaps are subject to a fair amount of CFTC regulation. Swaps must be cleared and traded on regulated central counterparties and multi-dealer trading platforms. Dealers and major users of swaps are also subject to capital, disclosure, and a host of other regulations. Swaps that are not subject to mandatory clearing are still subject to margin requirements, which may be fairly onerous once they are finalized.

Users of Bitcoin swaps may be able to escape the full scope of swaps regulation, however. Merchants that use Bitcoin swaps to hedge price risk would like qualify for the commercial end-user exemption from mandatory swaps clearing. In addition, to the extent a Bitcoin derivatives contract is structured and recognized by the CFTC as a contract involving a nonfinancial commodity intended for physical delivery, it will be deemed a forward contract and by definition excluded from any aspect of swaps regulation.

Finally, there is also the possibility that the Treasury Department may ultimately end up exempting physically settled Bitcoin swaps from the clearing mandate for the same reasons it did so for certain physically settled foreign exchange swaps; namely, because they are short-dated and don't pose a systemic risk.

Options are another type of derivative that may help to reduce Bitcoin volatility. They are basically regulated like swaps.

While it is certainly possible that the CFTC will create a unique regulatory framework specifically for virtual currencies like Bitcoin, it is more likely that its existing framework for futures and swaps regulation already provides a basis for understanding how Bitcoin derivatives will be eventually regulated.

For a deeper analysis of Bitcoin financial regulation, see my co-authored article here.

April 16, 2014

Almost all U.S. financial regulators have taken an official stance regarding Bitcoin and other virtual currencies.

The Treasury Deparment's Financial Crimes Enforcement Network (FinCEN) stated that companies sending or exchanging "convertible virtual currencies" like Bitcoin would be subject to anti-money laundering and related regulations. The Securities and Exchange Commission successfully argued in a suit that a Bitcoin-denominated investment scheme to invest in bitcoins was under its jurisdiction. By contrast, Federal Reserve Chair Janet Yellen said the U.S. central bank has no jurisdiction over Bitcoin. Even the Internal Revenue Service has weighed in, and categorized Bitcoin as property for tax purposes.

The one major financial regulator that has yet to make an official move on Bitcoin is the Commodity Futures Trading Commission (CFTC). But that hasn't stopped market participants. Already, there are several venues to trade Bitcoin derivatives.

But it's only a matter of time until the CFTC proposes new rules applicable to Bitcoin, brings enforcement actions, or at least issues some guidance.

So as the CFTC goes about regulating Bitcoin, here are some observations it should keep in mind.

First, Bitcoin should be categorized either as an "exempt commodity," like gold and other precious metals, or as an "excluded commodity," like currencies and other financial interests. The case for the fomer is that bitcoins are limited in number and capable of being physically delivered (at least in a digital sense). The case for the latter is that bitcoins are a currency substitute, at least in some contexts, and are also a broader financial interest due to the underlying Bitcoin block chain enabling far more than payments transactions. Alternatively, it may be better for the CFTC to harmonize its approach with FinCEN (and the People's Bank of China, for that matter) by defining a new category of "virtual commodity" that includes cryptocurrencies like Bitcoin.

Second, parties that trade Bitcoin derivatives probably intend for physical delivery and not a cash settlement for the value of the trade. For example, the Bitcoin options being offered on Derivabit are structured to result in physical delivery of bitcoins. The Derivabit Guide states that the “underlying [Bitcoin] is fully available if the call option holder chooses to exercise the option."

The same applies to MPEx, a Bitcoin securities and futures exchange. For example, the settlement terms for MPEx’s X.Eur contract contemplates physical delivery, “intend[ing] to market make an Euro based Bitcoin future with physical delivery for the foreseeable future."

The intent to settle Bitcoin physically is important. Physical settlement is one of the most important characteristics that determines whether a derivatives contract will be regulated. For example, while the CFTC regulates futures, it has no jurisdiction over forwards, which are contracts to physically trade commodities in the future at a price agreed to now. As the court in CFTC v. Erskine explained:

The purpose of [the] “cash forward” exception [to CFTC regulation] is to permit those parties who contemplate physical transfer of the commodity to set up contracts that . . . reduce the risk of price fluctuations, without subjecting the parties to burdensome regulations. These contracts are not subject to the CFTC regulations because those regulations are intended to govern only speculative markets; they are not meant to cover contracts wherein the commodity in question has an “inherent value” to the transacting parties.

This reasoning applies to Bitcoin derivatives. First, unlike agricultural commodities, bitcoins are easily transferable between parties. Indeed, a primary feature of bitcoins is that easier to transfer them than their cash-equivalent. And due to Bitcoin's price fluctuations, parties are likley attempting to reduce the risk associated with its volatility. Finally, unlike derivatives contracts themselves, as a means of payment and of potentially transferring property titles and performing other financial services, bitcoins have inherent value.

Similarly, options that entail physical delivery are exempt from CFTC regulation, but only if they are traded between entities that include financially sophisticated parties and commercial users, and don't involve fraud and manipulation.

Thus, the digital nature of bitcoins, along with their near costless transferability, suggest that derivatives transactions involving bitcoin intend for physical settlement. Accordingly, they should probably not be treated as fully regulated futures contracts.

February 05, 2014

The Intenational Swaps and Derivatives Association's (ISDA) much-awaited updates to its definitions for standardized credit derivatives contracts have been delayed until September 2014.

The delay is probably hindering the market for credit default swaps that pay protection buyers if a government borrower fails to pay its bonds. This is because the current standardized definitions do not include a failure to pay that results from a bail-in by creditors, which can leave buyers of CDSs not being fully compensated for their actual economic losses. (A bail-in takes place when the payment rights of creditors are delayed or reduced to improve the the financial condition of the borrower.)

A similar contract-definition problem exists with certain types of governmental restructurings and came to prominence when the Greek government forced an exchange on bondholders that was technically outside the scope of what triggers a payout to CDS holders.

But parties that want to trade sovereign CDSs that will pay out regardless of how governmental actions cause bondholder payment losses do not necessarily need to wait for ISDA's definitions to become official later this year.

ISDA has already published a draftof its revisions that include a broad definition of "Governmental Intervention" as an event that will trigger a payout to CDS protection buyers.

The revised draft definition of Governmental Intervention in Section 4.8 includes the following as grounds for a pay out:

"(i) any event which would affect creditors' rights so as to cause:

(A) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals (including by way of redenomination);

(B) a reduction in the amount of principal or premium payable at redemption (including by way of redenomination);

(C) a postponement or other deferral of a date or dates for either (A) the payment or accrual of interest or (B) the payment of principal or premium;

(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation; or

(E) any change in the currency of any payment of interest, principal or premium to any currency which is not a Standard Specified Currency (excluding any lawful currency of France or Germany (other than the euro) and any successor currency thereto);

(ii) an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events specified" above.

Under any reading of this definition, government initiated bail-ins and debt exchanges would qualify as a Governmental Intervention credit event.

Parties wanting to enter a CDS that triggers a pay out under such circumstances can adopt this (draft) definition in their current CDS. In addition, they can agree to incorporate any change in the final definition of Governmental Intervention on a prospective basis.

Although the sovereign CDS market will be best off waiting for ISDA's final revised credit derivatives definitions to come into effect, bondholders seeking to protect themselves now against all sorts of governmental interventions may want to move ahead of ISDA and incorporate the definitions into any new agreement themselves.

September 24, 2013

Five years after the financial crisis, one might think that the derivatives world hasn't really reformed. However, steady progress was already taking place years before the Dodd-Frank Act seeking to reform Wall Street was enacted.

A Lack of Official Progress

A popular notion is that policymakers may have wasted the financial crisis of 2008 by failing to quickly enact large scale regulation of over-the-counter derivatives and other areas of finance. Supporting this idea is the undeniable fact that derivatives regulators have yet to enact many of the regulations required by the Dodd-Frank Act of 2010.

As the long bar in the middle of the following chart from Davis Polk's September 2013 Dodd-Frank Status Report shows, regulators are way behind, having missed half of their deadlines.

The Financial Stability Board (FSB) also has a graphic illustrating the pace of derivatives reform globally. The lack of green in the following graph from the FSB's September 2013 status report on global market reforms shows that the reforms are overwhelming incomplete.

An in-depth investigation by Bloomberg reporters Silla Brush and Robert Schmidt provides at least a partial explanation. The authors detail the massive amounts of time and money spent by financial sector lobbyists to shape derivatives regulation, including how it applies to commercial firms, overseas trades, and the number of counterparties a regulated swaps trade must be made available to before a deal may be closed.

Market Evolution

But despite the lack of official progress and the millions spent by finance lobbyists, the simple fact is that the derivatives market has massively improved since the financial crisis.

For starters, the types of deals that triggered the bailout of American International Group, Inc. are no longer done. Synthetic mortgage-related securities that used credit derivatives to spread and magnify the risk from subprime mortgages are nonexistant. Investors, and even banks, seemed to have wised up (and the trades would no longer be profitable, in any case).

The plumbing underlying the derivatives market has moved out ahead of regulation as well. Through 2006 and 2007, dealers of credit and equity derivatives reduced a potentially dangerous backlog of outstanding trade confirmations and moved towards using electronic systems.

During and in the immediate aftermath of the financial crisis, the improvements continued. By year-end 2008, "netting" (or tear-ups) of redundant risk exposures reduced commercial banks' over-the-counter derivatives exposures by 88% (or just over $6 trillion). The use of collateral in derivatives transactions had been on an upswing as well, with 65% of trades subject to collateral agreements by year-end 2008--almost double the proportion in 2003. 2009 was also an important year: the Depository Trust Clearing Corporation began to obtain enough information to allow regulators to have a complete picture of all credit default swap trades, and the industry adopted the Big Bang contract standardization protocol which brought more order to the market.

And despite the full force of Dodd-Frank derivatives rules failing to become a reality, numerous improvements were recently made or are in the works. These improvements include industry-wide revisions to definitions in the context of sovereign debt restructurings and elsewhere, electronic transaction identifiers, more accurate and widely-available pricing services, and improved accounting standards.

Why Regulation Was Not Necessary for the Improvements

The foregoing improvements to over-the-counter derivatives markets did not require final regulations in part because regulators pressured the industry to reform and the Dodd-Frank Act indicated what would eventually be mandated.

But a more fundamental reason stems from the unique economics of derivatives. The trades create long-term relationships and dealers--the primary players in the market--take both sides. As I've explained in a previous article, the fact that dealers are counterparties to both buyers and sellers means that they do not act like typical "sell side" banks. Instead, they have an incentive for the market as a whole--both sell side and buy side--to function smoothly. Accordingly, dealers have an incentive to adopt reforms and get behind their widespread adoption.

There is no doubt that derivatives markets still have a lot of progress to make. Nonetheless, it would be a mistake to overlook real improvements simply because of the slow progress of new regulations being enacted.